The Objective in Corporate Finance
“If you don’t know where you are going, it does not matter how you get there”
Aswath Damodaran 1 First Principles
Invest in projects that yield a return greater than the minimum acceptable hurdle rate. • The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to the owners of the firm (if public, these would be stockholders). • The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics. Objective: Maximize the Value of the Firm
Aswath Damodaran 2 The Classical Viewpoint
Van Horne: "In this book, we assume that the objective of the firm is to maximize its value to its stockholders" Brealey & Myers: "Success is usually judged by value: Shareholders are made better off by any decision which increases the value of their stake in the firm... The secret of success in financial management is to increase value." Copeland & Weston: The most important theme is that the objective of the firm is to maximize the wealth of its stockholders." Brigham and Gapenski: Throughout this book we operate on the assumption that the management's primary goal is stockholder wealth maximization which translates into maximizing the price of the common stock.
Aswath Damodaran 3 The Objective in Decision Making
In traditional corporate finance, the objective in decision making is to maximize the value of the firm. A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price. All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization.
Aswath Damodaran 4 The Criticism of Firm Value Maximization
Maximizing stock price is not incompatible with meeting employee needs/objectives. In particular: • - Employees are often stockholders in many firms • - Firms that maximize stock price generally are firms that have treated employees well. Maximizing stock price does not mean that customers are not critical to success. In most businesses, keeping customers happy is the route to stock price maximization. Maximizing stock price does not imply that a company has to be a social outlaw.
Aswath Damodaran 5 Why traditional corporate financial theory focuses on maximizing stockholder wealth.
Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently). If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously. The objective of stock price performance provides some very elegant theory on: • how to pick projects • how to finance them • how much to pay in dividends
Aswath Damodaran 6 The Classical Objective Function
STOCKHOLDERS
Hire & fire Maximize managers stockholder - Board wealth - Annual Meeting Lend Money No Social Costs BONDHOLDERS Managers SOCIETY Protect Costs can be bondholder traced to firm Interests Reveal Markets are information efficient and honestly and assess effect on on time value
FINANCIAL MARKETS
Aswath Damodaran 7 What can go wrong?
STOCKHOLDERS
Managers put Have little control their interests over managers above stockholders
Lend Money Significant Social Costs BONDHOLDERS Managers SOCIETY Bondholders can Some costs cannot be get ripped off traced to firm Delay bad news or Markets make provide mistakes and misleading can over react information
FINANCIAL MARKETS
Aswath Damodaran 8 I. Stockholder Interests vs. Management Interests
Theory: The stockholders have significant control over management. The mechanisms for disciplining management are the annual meeting and the board of directors. Practice: Neither mechanism is as effective in disciplining management as theory posits.
Aswath Damodaran 9 The Annual Meeting as a disciplinary venue
The power of stockholders to act at annual meetings is diluted by three factors • Most small stockholders do not go to meetings because the cost of going to the meeting exceeds the value of their holdings. • Incumbent management starts off with a clear advantage when it comes to the exercising of proxies. Proxies that are not voted becomes votes for incumbent management. • For large stockholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet.
Aswath Damodaran 10 Board of Directors as a disciplinary mechanism
The Average Director: Underworked and Overpaid
140 50000
45000 120 Hours worked per year Annual Pay 40000
100 35000
30000 80
25000
60 Annual Pay 20000 Hours worked per year
15000 40
10000
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0 0 1985 1988 1992 1996 2000 Year
Aswath Damodaran 11 The CEO hand-picks most directors..
The 1992 survey by Korn/Ferry revealed that 74% of companies relied on recommendations from the CEO to come up with new directors; Only 16% used an outside search firm. Directors often hold only token stakes in their companies. The Korn/Ferry survey found that 5% of all directors in 1992 owned less than five shares in their firms. Many directors are themselves CEOs of other firms.
Aswath Damodaran 12 Directors lack the expertise to ask the necessary tough questions..
The CEO sets the agenda, chairs the meeting and controls the information. The search for consensus overwhelms any attempts at confrontation.
Aswath Damodaran 13 The Best Boards in 1997...
Aswath Damodaran 14 And the Worst Boards in 1997..
Aswath Damodaran 15 Who’s on Board? The Disney Experience - 1997
Aswath Damodaran 16 A Contrast: Disney vs. Campbell Soup in 1997
BEST PRACTICES CAMPBELL SOUP DISNEY Majority of outside directors Only one insider 7 of 17 members among 15 directors are insiders Bans insiders on nominating Yes No: CEO is committee chairman of panel Bans former execs from board Yes No Mandatory retirement age 70, with none None over 64 Outside directors meet w/o CEO Annually Never Appointment of 'lead director'' Yes No Governance committee Yes No Self-evaluation of effectiveness Every two years None Director pensions None Yes Share-ownership requirement 3,000 shares None
Aswath Damodaran 17 Application Test: Who’s on board?
Look at the board of directors for your firm. Analyze • How many of the directors are inside directors (Employees of the firm, ex-managers)? • Is there any information on how independent the directors in the firm are from the managers?
Aswath Damodaran 18 So, what next? When the cat is idle, the mice will play ....
No stockholder approval needed When managers do not fear stockholders, they will often put their interests over stockholder interests • Greenmail: The (managers of ) target of a hostile takeover buy out the potential acquirer's existing stake, at a price much greater than the price paid by the raider, in return for the signing of a 'standstill' agreement. • Golden Parachutes: Provisions in employment contracts, that allows for the payment of a lump-sum or cash flows over a period, if managers covered by these contracts lose their jobs in a takeover. … .. Stockholder Approval needed • Poison Pills: A security, the rights or cashflows on which are triggered by an outside event, generally a hostile takeover, is called a poison pill. • Shark Repellents: Anti-takeover amendments are also aimed at dissuading hostile takeovers, but differ on one very important count. They require the assent of stockholders to be instituted. • Overpaying on takeovers
Aswath Damodaran 19 Overpaying on takeovers
The quickest and perhaps the most decisive way to impoverish stockholders is to overpay on a takeover. The stockholders in acquiring firms do not seem to share the enthusiasm of the managers in these firms. Stock prices of bidding firms decline on the takeover announcements a significant proportion of the time. Many mergers do not work, as evidenced by a number of measures. • The profitability of merged firms relative to their peer groups, does not increase significantly after mergers. • An even more damning indictment is that a large number of mergers are reversed within a few years, which is a clear admission that the acquisitions did not work.
Aswath Damodaran 20 A Case Study: Kodak - Sterling Drugs
Eastman Kodak’s Great Victory
Aswath Damodaran 21 Earnings and Revenues at Sterling Drugs
Sterling Drug under Eastman Kodak: Where is the synergy?
5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 1988 1989 1990 1991 1992
Revenue Operating Earnings
Aswath Damodaran 22 Kodak Says Drug Unit Is Not for Sale (NYTimes, 8/93)
An article in the NY Times in August of 1993 suggested that Kodak was eager to shed its drug unit. • In response, Eastman Kodak officials say they have no plans to sell Kodak’s Sterling Winthrop drug unit. • Louis Mattis, Chairman of Sterling Winthrop, dismissed the rumors as “massive speculation, which flies in the face of the stated intent of Kodak that it is committed to be in the health business.” A few months later…Taking a stride out of the drug business, Eastman Kodak said that the Sanofi Group, a French pharmaceutical company, agreed to buy the prescription drug business of Sterling Winthrop for $1.68 billion. • Shares of Eastman Kodak rose 75 cents yesterday, closing at $47.50 on the New York Stock Exchange. • Samuel D. Isaly an analyst , said the announcement was “very good for Sanofi and very good for Kodak.” • “When the divestitures are complete, Kodak will be entirely focused on imaging,” said George M. C. Fisher, the company's chief executive. • The rest of the Sterling Winthrop was sold to Smithkline for $2.9 billion.
Aswath Damodaran 23 Application Test: Who owns/runs your firm?
Look at: Bloomberg printout HDS for your firm Looking at the top 15 stockholders in your firm, are top managers in your firm also large stockholders in the firm? Is there any evidence that the top stockholders in the firm play an active role in managing the firm?
Aswath Damodaran 24 Disney’s top stockholders in 2003
Aswath Damodaran 25 II. Stockholders' objectives vs. Bondholders' objectives
In theory: there is no conflict of interests between stockholders and bondholders. In practice: Stockholders may maximize their wealth at the expense of bondholders. • Increasing dividends significantly: When firms pay cash out as dividends, lenders to the firm are hurt and stockholders may be helped. This is because the firm becomes riskier without the cash. • Taking riskier projects than those agreed to at the outset: Lenders base interest rates on their perceptions of how risky a firm’s investments are. If stockholders then take on riskier investments, lenders will be hurt. • Borrowing more on the same assets: If lenders do not protect themselves, a firm can borrow more money and make all existing lenders worse off.
Aswath Damodaran 26 Unprotected Lenders?
Aswath Damodaran 27 III. Firms and Financial Markets
In theory: Financial markets are efficient. Managers convey information honestly and truthfully to financial markets, and financial markets make reasoned judgments of 'true value'. As a consequence- • A company that invests in good long term projects will be rewarded. • Short term accounting gimmicks will not lead to increases in market value. • Stock price performance is a good measure of management performance. In practice: There are some holes in the 'Efficient Markets' assumption.
Aswath Damodaran 28 Managers control the release of information to the general public
There is evidence that • they suppress information, generally negative information • they delay the releasing of bad news – bad earnings reports – other news • they sometimes reveal fraudulent information
Aswath Damodaran 29 Evidence that managers delay bad news..
DO MANAGERS DELAY BAD NEWS?: EPS and DPS Changes- by Weekday
8.00%
6.00%
4.00%
2.00%
0.00%
-2.00%
-4.00%
-6.00% Monday Tuesday Wednesday Thursday Friday
% Chg(EPS) % Chg(DPS)
Aswath Damodaran 30 Even when information is revealed to financial markets, the market value that is set by demand and supply may contain errors.
Prices are much more volatile than justified by the underlying fundamentals • Eg. Did the true value of equities really decline by 20% on October 19, 1987? financial markets overreact to news, both good and bad financial markets are short-sighted, and do not consider the long-term implications of actions taken by the firm • Eg. the focus on next quarter's earnings financial markets are manipulated by insiders; Prices do not have any relationship to value.
Aswath Damodaran 31 Are Markets Short term?
Focusing on market prices will lead companies towards short term decisions at the expense of long term value. a) I agree with the statement b) I do not agree with this statement
Aswath Damodaran 32 Are Markets Short Sighted? Some evidence that they are not..
There are hundreds of start-up and small firms, with no earnings expected in the near future, that raise money on financial markets If the evidence suggests anything, it is that markets do not value current earnings and cashflows enough and value future earnings and cashflows too much. • Low PE stocks are underpriced relative to high PE stocks The market response to research and development and investment expenditure is generally positive
Aswath Damodaran 33 Market Reaction to Investment Announcements
Type of Announcement Abnormal Returns on Announcement Day Announcement Month Joint Venture Formations 0.399% 1.412% R&D Expenditures 0.251% 1.456% Product Strategies 0.440% -0.35% Capital Expenditures 0.290% 1.499% All Announcements 0.355% 0.984%
Aswath Damodaran 34 IV. Firms and Society
In theory: There are no costs associated with the firm that cannot be traced to the firm and charged to it. In practice: Financial decisions can create social costs and benefits. • A social cost or benefit is a cost or benefit that accrues to society as a whole and NOT to the firm making the decision. – -environmental costs (pollution, health costs, etc..) – Quality of Life' costs (traffic, housing, safety, etc.) • Examples of social benefits include: – creating employment in areas with high unemployment – supporting development in inner cities – creating access to goods in areas where such access does not exist
Aswath Damodaran 35 Social Costs and Benefits are difficult to quantify because ..
They might not be known at the time of the decision (Example: Manville and asbestos) They are 'person-specific' (different decision makers weight them differently) They can be paralyzing if carried to extremes
Aswath Damodaran 36 A Hypothetical Example
Assume that you work for Disney and that you have an opportunity to open a store in an inner-city neighborhood. The store is expected to lose about $100,000 a year, but it will create much-needed employment in the area, and may help revitalize it. Questions: • Would you open the store? a) Yes b) No • If yes, would you tell your stockholders and let them vote on the issue? a) Yes b) No • If no, how would you respond to a stockholder query on why you were not living up to your social responsibilities?
Aswath Damodaran 37 So this is what can go wrong...
STOCKHOLDERS
Managers put Have little control their interests over managers above stockholders
Lend Money Significant Social Costs BONDHOLDERS Managers SOCIETY Bondholders can Some costs cannot be get ripped off traced to firm Delay bad news or Markets make provide mistakes and misleading can over react information
FINANCIAL MARKETS
Aswath Damodaran 38 Traditional corporate financial theory breaks down when ...
The interests/objectives of the decision makers in the firm conflict with the interests of stockholders. Bondholders (Lenders) are not protected against expropriation by stockholders. Financial markets do not operate efficiently, and stock prices do not reflect the underlying value of the firm. Significant social costs can be created as a by-product of stock price maximization.
Aswath Damodaran 39 When traditional corporate financial theory breaks down, the solution is:
To choose a different mechanism for corporate governance To choose a different objective: To maximize stock price, but reduce the potential for conflict and breakdown: • Making managers (decision makers) and employees into stockholders • By providing information honestly and promptly to financial markets
Aswath Damodaran 40 An Alternative Corporate Governance System
Germany and Japan developed a different mechanism for corporate governance, based upon corporate cross holdings. • In Germany, the banks form the core of this system. • In Japan, it is the keiretsus • Other Asian countries have modeled their system after Japan, with family companies forming the core of the new corporate families At their best, the most efficient firms in the group work at bringing the less efficient firms up to par. They provide a corporate welfare system that makes for a more stable corporate structure At their worst, the least efficient and poorly run firms in the group pull down the most efficient and best run firms down. The nature of the cross holdings makes its very difficult for outsiders (including investors in these firms) to figure out how well or badly the group is doing.
Aswath Damodaran 41 Choose a Different Objective Function
Firms can always focus on a different objective function. Examples would include • maximizing earnings • maximizing revenues • maximizing firm size • maximizing market share • maximizing EVA The key thing to remember is that these are intermediate objective functions. • To the degree that they are correlated with the long term health and value of the company, they work well. • To the degree that they do not, the firm can end up with a disaster
Aswath Damodaran 42 Maximize Stock Price, subject to ..
The strength of the stock price maximization objective function is its internal self correction mechanism. Excesses on any of the linkages lead, if unregulated, to counter actions which reduce or eliminate these excesses In the context of our discussion, • managers taking advantage of stockholders has lead to a much more active market for corporate control. • stockholders taking advantage of bondholders has lead to bondholders protecting themselves at the time of the issue. • firms revealing incorrect or delayed information to markets has lead to markets becoming more “skeptical” and “punitive” • firms creating social costs has lead to more regulations, as well as investor and customer backlashes.
Aswath Damodaran 43 The Stockholder Backlash
Institutional investors such as CalPERS and the Lens Funds have become much more active in monitoring companies that they invest in and demanding changes in the way in which business is done Individuals like Michael Price specialize in taking large positions in companies which they feel need to change their ways (Chase, Dow Jones, Readers’ Digest) and push for change At annual meetings, stockholders have taken to expressing their displeasure with incumbent management by voting against their compensation contracts or their board of directors
Aswath Damodaran 44 Disney’s Board in 2003
Board Members Occupation Reveta Bowers Head of school for the Center for Early Education, John Bryson CEO and Chairman of Con Edison Roy Disney Head of Disney Animation Michael Eisner CEO of Disney Judith Estrin CEO of Packet Design (an internet company) Stanley Gold CEO of Shamrock Holdings Robert Iger Chief Operating Officer, Disney Monica Lozano Chief Operation Officer, La Opinion (Spanish newspaper) George Mitchell Chairman of law firm (Verner, Liipfert, et al.) Thomas S. Murphy Ex-CEO, Capital Cities ABC Leo O’Donovan Professor of Theology, Georgetown University Sidney Poitier Actor, Writer and Director Robert A.M. Stern Senior Partner of Robert A.M. Stern Architects of New York Andrea L. Van de Kamp Chairman of Sotheby's West Coast Raymond L. Watson Chairman of Irvine Company (a real estate corporation) Gary L. Wilson Chairman of the board, Northwest Airlines.
Aswath Damodaran 45 The Hostile Acquisition Threat
The typical target firm in a hostile takeover has • a return on equity almost 5% lower than its peer group • had a stock that has significantly under performed the peer group over the previous 2 years • has managers who hold little or no stock in the firm In other words, the best defense against a hostile takeover is to run your firm well and earn good returns for your stockholders Conversely, when you do not allow hostile takeovers, this is the firm that you are most likely protecting (and not a well run or well managed firm)
Aswath Damodaran 46 The Bondholders’ Defense Against Stockholder Excesses
More restrictive covenants on investment, financing and dividend policy have been incorporated into both private lending agreements and into bond issues, to prevent future “Nabiscos”. New types of bonds have been created to explicitly protect bondholders against sudden increases in leverage or other actions that increase lender risk substantially. Two examples of such bonds • Puttable Bonds, where the bondholder can put the bond back to the firm and get face value, if the firm takes actions that hurt bondholders • Ratings Sensitive Notes, where the interest rate on the notes adjusts to that appropriate for the rating of the firm More hybrid bonds (with an equity component, usually in the form of a conversion option or warrant) have been used. This allows bondholders to become equity investors, if they feel it is in their best interests to do so.
Aswath Damodaran 47 The Financial Market Response
While analysts are more likely still to issue buy rather than sell recommendations, the payoff to uncovering negative news about a firm is large enough that such news is eagerly sought and quickly revealed (at least to a limited group of investors) As information sources to the average investor proliferate, it is becoming much more difficult for firms to control when and how information gets out to markets. As option trading has become more common, it has become much easier to trade on bad news. In the process, it is revealed to the rest of the market (See Scholastic) When firms mislead markets, the punishment is not only quick but it is savage.
Aswath Damodaran 48 The Societal Response
If firms consistently flout societal norms and create large social costs, the governmental response (especially in a democracy) is for laws and regulations to be passed against such behavior. • e.g.: Laws against using underage labor in the United States For firms catering to a more socially conscious clientele, the failure to meet societal norms (even if it is legal) can lead to loss of business and value • e.g. Specialty retailers being criticized for using under age labor in other countries (where it might be legal) Finally, investors may choose not to invest in stocks of firms that they view as social outcasts. • e.g.. Tobacco firms and the growth of “socially responsible” funds (Calvert..)
Aswath Damodaran 49 The Counter Reaction
STOCKHOLDERS
1. More activist Managers of poorly investors run firms are put 2. Hostile takeovers on notice.
Protect themselves Corporate Good Citizen Constraints BONDHOLDERS Managers SOCIETY 1. Covenants 1. More laws 2. New Types 2. Investor/Customer Backlash Firms are punished Investors and for misleading analysts become markets more skeptical
FINANCIAL MARKETS
Aswath Damodaran 50 So what do you think?
At this point in time, the following statement best describes where I stand in terms of the right objective function for decision making in a business a) Maximize stock price or stockholder wealth, with no constraints b) Maximize stock price or stockholder wealth, with constraints on being a good social citizen. c) Maximize profits or profitability d) Maximize market share e) Maximize Revenues f) Maximize social good g) None of the above
Aswath Damodaran 51 The Modified Objective Function
For publicly traded firms in reasonably efficient markets, where bondholders (lenders) are protected: • Maximize Stock Price: This will also maximize firm value For publicly traded firms in inefficient markets, where bondholders are protected: • Maximize stockholder wealth: This will also maximize firm value, but might not maximize the stock price For publicly traded firms in inefficient markets, where bondholders are not fully protected • Maximize firm value, though stockholder wealth and stock prices may not be maximized at the same point. For private firms, maximize stockholder wealth (if lenders are protected) or firm value (if they are not)
Aswath Damodaran 52